International Taxation

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International Taxation

• Introduction
• Howard Godfrey, Ph.D., CPA

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• International Taxation
• The U.S. imposes taxes on worldwide income of
  U.S. taxpayers (citizens, resident aliens and
  corporations organized in the U.S.).
• The U.S. imposes taxes on non-resident aliens
  (not U.S. citizens) and non-resident entities on
  income earned in the U.S.
• A foreign person, who becomes a U.S. resident, is
  taxed like a U.S. citizen (on worldwide income).
• A foreign owned corp. that is organized in this
  country is subject to U.S. income taxes. Etc.

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Notes for case for Bud

• Please note that the case for Bud involves a U.S.
  tax person. Same principles apply for a U.S.
  corporation with a branch in the foreign country,
  or a U.S. proprietorship with a branch operation
  in the foreign country.
• These concepts do not apply to a foreign person
  with income earned in the U.S.(Alien working in
  U.S., etc.)

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• Please note the variety of ways the tax systems
  of various countries may interact with each
  other.
• In a territorial system, each country imposes
  taxes on income earned in its territory.
• In a world-wide or global system, a county taxes
  income earned worldwide by its citizens. This may
  cause income to be taxed in more than one
  country.
• Double taxation. Credits allowed, etc.

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• The following slides involve the taxation of
  income earned in the U.S. and income earned in
  the U.K.
• The tax rates are hypothetical and various
  assumptions are made regarding the nature of the
  tax systems territorial, world-wide, etc.
• The examples are designed to illustrate important
  concepts and may not accurately reflect the tax
  systems actually in effect in the countries.

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• Note you can repeat the slides above for a U.S.
  Corporation. The U.S. corporation has net income
  from U.S. operations of 100,000 and net income
  from a branch office in a foreign country.
• The same principles apply.
• Other rules apply for foreign Sub.

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• Note The first slide (results) for Bud involves
  him simply excluding the income earned in a
  foreign country. That is the essence of Sec. 911,
  which allows a worker in a foreign country to
  exclude 80,000 per year, as well as certain
  housing costs.

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• Look at Example 16-3 and the preceding formula
  for the tax credit limit.
• What happens if she also earns some interest
  income in a foreign country that does not impose
  an income tax.
• Would that cause the value of the fraction on the
  tax credit formula slide to be larger, leading to
  a larger credit limit?
• No. See Tax Credit Limits example 16-4
• Baskets and separate limits for them!!!!!

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• Foreign Tax Credit
• Jackson Corp.s taxable income for 2006 from all
  of its global operations was 500,000, resulting
  in U.S. federal income tax of 200,000 before
  credits. Jacksons taxable income from foreign
  sources was 125,000 during 2006. Jackson paid
  income taxes of 60,000 to foreign governments.
  What is Jacksons foreign tax credit limitation
  for 2006?
• a. 200,000 b. 60,000
• c. 50,000 d. 12,500

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Foreign Earned Income Exclusion

• CHOOSING A DEDUCTION, CREDIT OR EXCLUSION
• A taxpayer should carefully choose between (1) a
  deduction for foreign income taxes,
• (2) a credit on for foreign income taxes, or
• (3) an exclusion of up to 80,000 of foreign
  earnings from U.S. gross income.

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Case 1-1

• Case 1. A U.S. citizen has the opportunity to
  earn an extra 100,000, and that income is earned
  in a foreign country. The taxpayers U.S. income
  tax is 30,000 (marginal rate of 30) on the
  foreign income and the foreign government imposes
  an income tax of 20,000 on that income.

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Case 1-3

• The Code provides a deduction for foreign income
  taxes paid. A deduction of 20,000 for these
  taxes will generate a tax savings of 6,000 (30
  of 20,000).
• However, a tax credit for these foreign taxes
  will yield a savings on U.S. income tax of
  20,000.
• The greatest saving is realized by excluding
  100,000 from U.S. income, thereby saving U.S.
  income tax of 30,000.

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Case 1-4

• Best situation is to earn tax-free income in
  foreign country and exclude it from the U.S.
  income tax computations.

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Foreign Earned Income Exclusion

• Section 911 provides an (a)
• (1) exclusion of up to 80,000 of foreign earned
  income
• (2) exclusion for foreign housing costs by
  employees and
• (3) deduction of certain foreign housing costs by
  self-employed individuals.

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Foreign Earned Income Exclusion

• Sara applies for and receives a work assignment
  in England for Big Corp. She moved to London on
  1-1-2006. She worked and lived there continuously
  until the middle of 2007, when she returned to
  the U.S. Her salary is 200,000 per year, in both
  2006 and 2007. What is the amount of her foreign
  earned income exclusion for 2007?
• a. 0 b. 40,000 c. 60,000 d. 80,000

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Foreign Earned Income Exclusion

• A taxpayer working in a foreign country reports
  total world-wide income on Form 1040 and then
  takes a deduction for AGI for the exclusions
  provided by Section 911. In effect, the
  exclusions are taken via deductions on the Form
  1040.

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Foreign Earned Income Exclusion

• The terms foreign, abroad and overseas
  refer to a situation in which a taxpayer lives
  and works in a foreign country.

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Foreign Earned Income Exclusion

• Regular Tax Rules Continue to Apply. A taxpayer
  working abroad is subject to all of the tax rules
  applicable to those living in this country, and
  must deal with additional rules that are uniquely
  applicable those with foreign income.

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Foreign Earned Income Exclusion

• Regular Tax Rules Continue to Apply. Worldwide
  income is reported on the Form 1040, even though
  the foreign income may be subject to foreign
  income taxes as well.

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Foreign Earned Income Exclusion

• A taxpayer working abroad is subject to the
  regular rules that require inclusion in income of
  all fringe benefits that do not qualify for
  exclusion under Section 132 or other sections of
  the code. For example, fringe benefits in the
  form of the right to use the employers property
  or facilities are fully taxable unless excluded
  under Section 119.

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Foreign Earned Income Exclusion

• Case 1. A taxpayer lives in Japan and is employed
  there all year. He receives a salary of 6,000 a
  month. He lives rent-free in a house provided by
  the employer that has a fair rental value of
  3,000 a month. The house is not provided for the
  employers convenience. The taxpayer has 72,000
  salary from foreign sources plus 36,000 fair
  rental value of the house, for a total of
  108,000 of foreign earned income.
• These amounts may be excluded as foreign housing
  costs or as part of foreign earned income.

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Foreign Earned Income Exclusion

• Self-Employment Tax. A self-employed taxpayer is
  generally subject to the same rules for paying
  self-employment tax whether he lives in the
  United States or abroad.

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Foreign Earned Income Exclusion

• Case 2. A consultant works abroad and qualifies
  for the foreign earned income exclusion. Foreign
  gross income is 95,000, business deductions
  total 27,000, and net profit is 68,000.

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Foreign Earned Income Exclusion

• Case 2.
• Self-employment tax is paid on all of net profit,
  including the amount excluded from income for
  regular income tax purposes (unless there is an
  agreement with the foreign country so that only
  one country imposes social security tax or S.E
  tax ).

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Foreign Earned Income Exclusion

• Allocating Income to a Tax Year. The foreign
  earned income exclusion of up to 80,000 per year
  makes it important to accurately identify the
  year in which foreign income is earned.

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Foreign Earned Income Exclusion

• Case 3. A taxpayer in a foreign country has
  tax-free income of 160,000 over a two-year
  period when he earns 80,000 in 2005 and 80,000
  in 2006. If the same taxpayer earns 70,000 in
  2005 and 90,000 in 2006, he will have tax-free
  income of only 150,000 in the same two year
  period.

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Foreign Earned Income Exclusion

• Case 3. However, assume the compensation of
  90,000 received in 2006 actually included a
  bonus of 10,000 for service in 2005. In this
  case, he will qualify for an exclusion of 90,000
  on the 2006 tax return consisting of 80,000
  for 2006 and 10,000 of the unused exclusion from
  2005.

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Foreign Earned Income Exclusion

• When working with compensation for services, it
  is necessary to compute the amount of gross
  income to be excluded, and then disallow the
  deductions for certain expenditures that are
  identified with excluded income.

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Foreign Earned Income Exclusion

• Case 4. An employee works for an employer for the
  entire year but works in a foreign country for
  only 11 months of the year. Only the gross income
  earned in the foreign country will be excluded,
  up to a prorated amount of the 80,000 maximum
  exclusion.

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Foreign Earned Income Exclusion

• Case 4 Contd.
• A deduction for unreimbursed employee expenses
  will be disallowed, to the extent they relate to
  gross income that is excluded.

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Questions to Ask About Income

1. Is the income required to be included in gross
   income under general tax rules?
2. Is the income classified as U.S. income or
   foreign source income?
3. Is the income classified as earned income?
4. In what year was the income earned? (It is
   generally allocated to the year in which it was
   earned, and is subject to the annual exclusion
   limit for that year).

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Foreign Earned Income Exclusion

• The benefits of Section 911 are available even
  though the foreign earned income may be
  tax-exempt in the foreign country. This means a
  U.S. citizen or resident alien working in a
  foreign country may earn income that is entirely
  free of income taxes. Investment income and other
  income that is not considered foreign earned
  income are not covered by Section 911.

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Foreign Earned Income Exclusion

• Section 911(a) of the Code allows a "qualified
  individual," as defined in 911(d)(1), to exclude
  foreign earned income and housing cost amounts
  from gross income.
• Section 911(c)(4) of the Code allows a qualified
  individual to deduct housing cost amounts from
  gross income.

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Foreign Earned Income Exclusion

• Section 911(d)(1) of the Code defines the term
  "qualified individual" as an individual whose tax
  home is in a foreign country and who is
• (A) a citizen of the United States and
  establishes to the satisfaction of the Secretary
  of the Treasury that the individual has been a
  bona fide resident of a foreign country or
  countries for an uninterrupted period that
  includes an entire taxable year, or

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Foreign Earned Income Exclusion

• Section 911(d)(1) of the Code defines the term
  "qualified individual" as an individual whose tax
  home is in a foreign country and who is
• ---
• (B) a citizen or resident of the United States
  who, during any period of 12 consecutive months,
  is present in a foreign country or countries
  during at least 330 full days.

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Foreign Earned Income Exclusion

• 26 U.S.C. 911(a)(1). "Foreign earned income" is
  the amount an individual receives "from sources
  within a foreign country ... which constitutes
  earned income attributable to services performed
  by such individual" during the applicable time
  period described in 26 U.S.C. 911(d)(1)(A) or
  (B).

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Foreign Earned Income Exclusion

• Under 911(d)(1)(A) or (B), to qualify for the
  exclusion, the individual's tax home must be in a
  foreign country and the individual must be a
  United States citizen who has been a bona fide
  resident of the foreign country for the entire
  tax year or a United States citizen or resident
  who has been present in the foreign country for
  at least 330 full days of twelve consecutive
  months. See also 26 C.F.R. 1.911-2(a).

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Foreign Earned Income Exclusion

• The regulations define a "foreign country" as
  "any territory under the sovereignty of a
  government other than that of the United States,"
  id. 1.911-2(h), and "United States" to "include
  any territory under the sovereignty of the United
  States," including its "possessions and
  territories," id. 1.911-2(g).

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Exclusion Example

• The following slides contain an example that
  illustrates the overall procedure.

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Foreign Operations

• The easiest way for a U.S. enterprise to engage
  in global commerce is simply to sell
  U.S.-produced goods and services abroad. These
  sales can be conducted with little or no foreign
  presence and allow the business to explore
  foreign markets without making costly financial
  commitments to foreign operations.

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Foreign Operations

• The U.S. tax consequences of simple export sales
  are straightforward. All such income is taxed in
  the United States to the U.S. taxpayer. Whether
  foreign taxes must be paid on this export income
  depends on the particular law of the foreign
  jurisdiction and whether the U.S. taxpayer is
  deemed to have a foreign business presence there
  (often called a "permanent establishment").

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Foreign Operations

• Tax rules applicable to U.S. persons that control
  business operations in foreign countries depend
  on whether the business operations are conducted
  directly (through a foreign branch, for example)
  or indirectly (through a separate foreign
  corporation).

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Foreign Operations

• A U.S. person that conducts foreign operations
  directly includes the income and losses from such
  operations on the person's U.S. tax return for
  the year the income is earned or the loss is
  incurred.

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Alt. Forms for Foreign Operations

• Detailed rules are provided for the translation
  into U.S. currency of amounts with respect to
  such foreign operations. The income from the U.S.
  person's foreign operations thus is subject to
  current U.S. tax. However, the foreign tax credit
  may reduce or eliminate the U.S. tax on such
  income.

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Alt. Forms for Foreign Operations

• A U.S. company can enter foreign markets in a
  number of ways.
• It may simply hire foreign sales representatives
  to market its products in other countries.
• It may permit unrelated foreign companies to use
  patents, processes and trademarks that it
  developed through licensing arrangements.

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Alt. Forms for Foreign Operations

• These two alternatives involve no physical
  presence by the U.S. company in the foreign
  jurisdiction thus, the income earned might or
  might not be subject to foreign taxes, depending
  on the applicable treaty provisions if a treaty
  exists.

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Alt. Forms for Foreign Operations

• To expand foreign operations, having a physical
  presence in the foreign country can become
  necessary.
• The legal form for establishing this presence has
  four basic alternatives and is critical to
  determining the U.S. tax consequences of the
  resulting foreign income.

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Foreign Branch Operations

• First the U.S. corporation can simply establish a
  branch office in the foreign country.
• Such a branch is not a legal entity distinct from
  the U.S. Corporation thus any income it earns is
  included in worldwide taxable income.
• If the U.S. corporation pays taxes in the foreign
  country on branch earnings, it can claim a
  foreign tax credit subject to the same rules and
  limits.

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Alt. Forms for Foreign Operations

• Second, the U.S. corporation could conduct
  operations in partnership with others. Its share
  of partnership income is subject to U.S. taxation
  The corporation's share of any foreign income
  taxes paid on partnership earnings is assed
  through to the corporation and is includible in
  its foreign tax credit.

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• Foreign Branch Operations

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Foreign Branch Operations

• Sections 985 through 989 of the Internal Revenue
  Code of 1986 to provide rules for the treatment
  of foreign currency transactions. Section 985(a)
  provides that, unless otherwise provided in
  regulations, all determinations under subtitle A
  of the Code shall be made in the taxpayer's
  functional currency (as defined in section
  985(b)).

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Alt. Forms for Foreign Operations

• Second, the U.S. corporation could conduct
  operations in partnership with others. Its share
  of partnership income is subject to U.S. taxation
  The corporation's share of any foreign income
  taxes paid on partnership earnings is assed
  through to the corporation and is includible in
  its foreign tax credit.

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Alt. Forms for Foreign Operations

• The third and fourth alternatives involve the
  formation of a controlled subsidiary to conduct
  foreign operations,
• incorporated in either the United States or a
  foreign country.

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• Foreign Corporate Operations

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Alt. Forms for Foreign Operations

• Controlled Subsidiaries
• For tax and nontax purposes, the U.S. corporation
  might wish to establish a controlled subsidiary
  to engage in foreign operations.
• Such a subsidiary is a separate legal entity with
  the U.S. corporation as the controlling (often
  sole) shareholder.

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Alt. Forms for Foreign Operations

• Controlled Subsidiaries
• In many foreign countries, legal restrictions
  exist on foreign ownership of property. Thus,
  operation through a foreign subsidiary might be
  the only feasible alternative. In other
  countries, so-called branch profits taxes could
  discourage the use of a branch operation and
  favor the establishment of a subsidiary. The
  optimal choice varies from country to country and
  situation to situation.

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Alt. Forms for Foreign Operations

• Taxation of the controlled subsidiary's earnings
  depends on whether the subsidiary is incorporated
  in the United States or in a foreign country.
• A controlled U.S. subsidiary's income is subject
  to U.S. taxation when earned under general
  corporate tax rules.

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Alt. Forms for Foreign Operations

• If the controlled U.S. sub pays dividends to its
  parent, the dividends typically qualify for the
  100 percent dividends-received deduction and thus
  produce no U.S. tax at the time of repatriation.
  The U.S. parent's consolidated tax return
  includes the controlled U.S. subsidiary, and the
  consolidated group claims a foreign tax credit
  related to the subsidiary's foreign income and
  foreign taxes paid.

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Alt. Forms for Foreign Operations

• A controlled foreign sub. is not an eligible
  corporation for purposes of consolidated return
  rules and thus cannot be included in the U. S.
  parent corporation's consolidated tax return.
• However, the income of a controlled foreign
  subsidiary is not subject to U.S. taxation when
  it is earned.

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Alt. Forms for Foreign Operations

• Instead, earnings of a foreign subsidiary escape
  U.S. taxation until earnings are repatriated to
  the U.S., meaning when they are paid to the U.S.
  parent corporation as a dividend.
• The foreign jurisdiction probably taxes the
  income when earned and might also assess a tax on
  any dividend payments to the U.S. parent.

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Alt. Forms for Foreign Operations

• When a foreign subsidiary pays a dividend to its
  U.S. parent, it is paying out net earnings after
  paying foreign taxes. For U.S. tax purposes, the
  parent corporation recognizes dividend income
  equal to the gross earnings (before reduction by
  the foreign taxes paid) and then takes a deemed
  paid foreign tax credit for the applicable tax
  amount

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Alt. Forms for Foreign Operations

• Taxable dividend income equals the net dividend
  received plus any foreign withholding tax on the
  dividend distribution plus foreign taxes paid by
  the controlled foreign subsidiary on the income
  from which the dividend is distributed. Note that
  dividends received from foreign corporations are
  not eligible for the dividends-received
  deduction, so the total grossed up amount of the
  dividend is subject to U.S. tax.

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• Alt. Forms for Foreign Operations
• Charlotte Corp.s taxable income for 2006 from
  all of its global operations was 1,000,000,
  resulting in U.S. federal income tax of 340,000
  before credits. Charlottes wholly owned
  subsidiary (which is incorporated in a foreign
  country) earned net income of 200,000 in the
  foreign country in 2006. Charlotte received no
  dividend from the foreign subsidiary in 2006, but
  received a dividend of 50,000 in 2007. Charlotte
  reports (on its U.S. corporate tax return) income
  of its foreign subsidiary of
• a. 200,000 for 2006 b. 200,000 for 2007
  
• c. 50,000 for 2006 d. 0 in 2006 0 in 2007

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Alt. Forms for Foreign Operations

• Repeat the preceding question, except assume that
  the income of the subsidiary is Subpart F income.
• Charlotte reports (on its U.S. corporate tax
  return) income of its foreign subsidiary of
• a. 200,000 for 2006
• b. 200,000 for 2007
• c. 50,000 for 2007
• d. 0 in 2006 and 0 in 2007

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US Corp and Subsidiary

• The following slide summarizes the transactions
  of a U.S. parent corporation (USC) and its wholly
  owned subsidiary corporation organized and
  operating in the Cayman Islands (CSub).
• Parent (USC) manufactures widgets in the U.S.
  sells them to its Cayman Subsidiary (CSub).
• The Cayman Subsidiary sells the widgets in other
  parts of the world.
• Initially, we ignore transfer pricing limits and
  subpart F.

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• What happens if we change our intercompany
  pricing policy, and sell the widgets to the
  Cayman subsidiary at our cost, so that we
  break-even in the United States?

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Subpart F

• Suppose in the preceding slide, USC is actually
  selling its product to various customers
  throughout the world.
• The Cayman Islands sub is a sales agent (paper
  corporation) that technically buys from USC for
  600,000 and sells to USCs customers for
  1,000,000.
• The products are shipped directly to USCs
  customers and USC actually handles the billing,
  etc.If CSub does not produce in the Cayman
  Islands and does not sell in the Cayman Islands,
  Subpart F comes into play. USC is treated as
  receiving a distribution of CSub earnings on the
  last day of the year. See bottom of page 16-26

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Subpart F

• Suppose in the preceding slide, USC is actually
  selling its product to a wholly owned German
  Subsidiary.
• USC uses the Cayman Islands sub as a sales agent
  to buy from USC for 600,000 and sell to the
  German Subsidiary for 1,000,000.
• German subsidiary will sell the products in
  Germany for 1,000,000.
• Without transfer pricing limits or Subpart F,
  there would be no profit to be taxed in the U.S.
  or in Germany.

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Transfer Pricing

• The variance in tax rates and tax systems among
  countries, provide a strong incentive for a
  multinational enterprise to shift income,
  deductions, or tax credits among commonly
  controlled entities in order to arrive at a
  reduced overall tax burden.
• Such a shifting of items between commonly
  controlled entities could be accomplished by
  setting artificial transfer prices for
  transactions between group members.

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Transfer Pricing

• Assume that a U.S. corp. has a wholly-owned
  foreign sub.
• The U.S. corp. manufactures a product
  domestically and sells it to the foreign
  subsidiary. The foreign sub., in turn, sells the
  product to unrelated third parties. Due to the
  U.S. parent's control of its subsidiary, the
  price which is charged by the parent to the
  subsidiary theoretically could be set
  independently of ordinary market forces.

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Transfer Pricing

• If the foreign sub is established in a
  jurisdiction that subjects its profits from the
  sale of the product to an effective rate of tax
  lower than the effective U.S. tax rate, then the
  U.S. corp may be inclined to undercharge the
  foreign subsidiary for the product.

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Transfer Pricing

• By doing so, a portion of the combined profits of
  the group from the manufacture and sale of the
  product would be shifted out of a high-tax
  jurisdiction (the U.S.) and into a lower-tax
  jurisdiction (the foreign corporation's home
  country).

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Transfer Pricing

• By contrast, U.S. companies owning foreign
  subsidiaries that are located in countries with
  effective tax rates that are higher than the U.S.
  rates may have an incentive to overcharge for
  sales from the U.S. parent to the foreign
  subsidiary in order to shift profits, and the
  resulting tax, into the United States. The
  ultimate result of this process would be a
  reduced worldwide tax liability of the
  multinational enterprise.

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Transfer Pricing

• Under section 482, the Secretary of the Treasury
  is authorized to redetermine the income of an
  entity subject to U.S. taxation, when it appears
  that an improper shifting of income between that
  entity and a commonly controlled entity in
  another country has occurred.

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• Now take a look at kind of double taxation.

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• Harold Arrowsmith
• This controversy arose in connection with the
  estate of Harold Arrowsmith (hereinafter
  "decedent"), who died intestate in Germany on
  August 15, 1989. He was born, raised, and
  educated in Baltimore, Maryland and received a
  degree from the Johns Hopkins University in 1950.
  He continued to live in Maryland until 1974 when
  he sold his house and put his furniture in
  storage.

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• He briefly resided in an apartment-hotel in
  Washington, D.C., but moved to Germany in 1975.
  Although the decedent remained a U.S. citizen his
  entire life, filed U.S. income tax returns, and
  maintained a Maryland driver's license, he
  returned only occasionally to the United States
  to present the results of his research and
  writings.

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• His assets in Maryland consisted almost entirely
  of intangible personal property, specifically
  publicly-traded securities worth nearly 30
  million, held at the Mercantile-Safe Deposit and
  Trust Company.

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• The decedent's heirs initially filed a petition
  for probate in Baltimore County in September
  1989, asserting that because "the decedent was
  domiciled in Maryland and a majority of his
  assets are located in this state," the Register
  of Wills for Baltimore County (hereinafter "the
  Register") was the proper office in which to file
  the petition.

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• On May 14, 1990, the appellees paid 2,000,000 to
  the Register in inheritance taxes.
• About that time, the estate also paid Maryland
  and Federal estate taxes, in the amount of
  1,957,164 and 11,010,462, respectively.

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• Concurrent with the administration of the
  decedent's estate in the United States, parallel
  probate proceedings were initiated in Germany.
  Unable to ascertain the decedent's heirs, the
  German tax authorities appointed a curator to
  administer his estate under German law.
• Concluding that at the time of his death the
  decedent was domiciled in Germany, the German tax
  authorities asserted that Germany was entitled to
  the inheritance taxes on his entire worldwide
  estate.

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• The total German tax assessed was approximately
  17,511,145.
• The German curator turned over all of the
  decedent's assets located in Germany, totaling
  1,022,355, to the German tax authorities as
  partial payment of the assessed taxes, leaving an
  unpaid German inheritance tax balance of
  approximately 16,488,790, exclusive of interest
  and administrative penalties for failure to file
  timely returns or make timely payment.

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• What do you say?
• Did you notice the grand total of taxes?

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